Overdraft Protection Rules Could Hurt Consumers More Than They Help

Bank overdraft protection has come under close scrutiny from the Consumer Financial Protection Bureau. This summer, several researchers at the CFPB released a study that provides information about the patterns of overdraft protection use by consumers at several large banks, focusing particularly on use by the small category of consumers who use overdraft protection regularly.

While the new data and analysis provided by the CFPB advances our understanding of the use of overdraft protection, it does not address several key questions that must be answered before the CFPB imposes new regulations.

First, while the focus of the report is on the large banks over which the CFPB exercises supervisory authority, community banks are much more heavily dependent on revenues from overdraft protection than larger banks. Twenty-seven percent of bank income at smaller banks is generated by overdraft protection fees, compared to 12% at larger banks, according to our analysis of data from the Federal Deposit Insurance Corp. If the CFPB takes steps that reduce overdraft revenue, community banks will be much more adversely impacted than large banks.

Moreover, while large banks have dramatically curtailed access to free checking as a result of the Dodd-Frank Act, small banks continue to offer the product. Any major hit to small banks' overdraft fee revenue will inevitably be passed on to their customers in higher bank fees, higher minimum balance requirements for free checking or reduced services.

It is also important to note that there is no evidence that low-income consumers disproportionately use overdraft protection. As we observe in our commentary on the CFPB report, "While … many low-income consumers are beneficiaries of free checking, there is no indication that usage of overdraft protection has regressive effects. For example, an analysis of a regional community bank in Texas indicates that after geocoding its accounts, approximately 70% of overdraft users are classified as either upper income (30%) or middle income (40%) and 30% of active users represent moderate income (27%) or low income users (3%)."

Overdraft protection started as a benefit to high-income consumers, but as a result of automated overdraft protection programs, it has filtered down to ordinary bank customers. This data is consistent with prior studies that have found consistently that the only statistically meaningful predictor of overdraft protection use is the customer's credit score. No demographic variables (including income) are predictive after controlling for customer risk. In other words, available evidence does not support the CFPB's suggestion that overdraft protection somehow preys on poor people.

Third, before the CFPB takes steps to reduce access to overdraft protection, it must consider the costs of alternatives for consumers. Consumers who use overdraft protection frequently overwhelmingly report that they have poor credit and limited credit choices. For most frequent users of overdraft protection, payday lending is a likely alternative. This might be a more expensive option, depending on the individual customer's situation.

A rigorous economic analysis would consider all of the costs of overdraft protection and alternatives. For example, while other products such as payday loans may sometimes be less expensive in pure dollars, that calculation excludes the full cost, such as the time and inconvenience of acquiring a payday loan or the value of immediate access to a funds advance.

In recent decades, overdraft protection has emerged as a valuable source of revenue for America's community banks. It promotes free checking and has served as a lifeline for many credit-impaired consumers seeking alternatives to payday lending and pawn shops.

Wise, data-driven policy-making should be aware of the limits of currently available data and the possibility that restricting overdrafts will have unintended consequences. While information and solid empirical study such as the CFPB's admirable analysis are welcome, the agency should be aware that many unanswered questions remain before it should move on regulation in this area. 

G. Michael Flores is chief executive of consultancy Bretton Woods. Todd Zywicki is a George Mason University Foundation Professor of Law, senior scholar at GMU's Mercatus Center and co-author of Consumer Credit and the American Economy.